Second crisis looms

Austerity has become the rule when public expenditure should be replacing debt-financed private expenditure as the stimulus for growth.

It will soon be five years since the onset of the financial crisis and the Great Recession that has occupied the worlds attention. Five years of downside news about high unemployment, slow growth, damaged household budgets and paralysed governments. Much of the worlds population has become tired not just of living through the crisis, but of having to read about it and hear it repeatedly discussed without any solution in sight.

But now it seems they are about to receive a wake-up call. The evidence seems to suggest that the world economy is shifting from a scenario of recession as usual to a second crisis, with even lower prospects of recovery. There are three signals, among many, of that likelihood that are particularly telling. The first is, of course, the mess in Europe. There is reason to believe that the crisis would not just intensify in Greece and Spain but would spread to Italy and even France. The quarter-on-quarter annual growth rate in the group of 27 European Union countries fell to near zero in the first quarter of 2012, from 2.44 per cent a year earlier. This is because countries that were doing well and pulling up the average, like Germany, are now being overcome by the crisis themselves.

The second is that the United States, where intervention to save the banks and spending to reverse the recession seemed to have begun to work with rising growth rates and falling unemployment, is once again showing signs of losing steam. Real gross domestic product (GDP) increased at an annual rate of 1.9 per cent in the first quarter of 2012 relative to the previous quarter (that is, the fourth quarter of 2011). On the same basis, real GDP increased 3.0 per cent in the fourth quarter of 2011. Meanwhile, the increase in the number of non-farm jobs began showing a reversing trend, resulting in the unemployment rate staying stubbornly above 8 per cent, though many people had pulled out of the workforce convinced that a job search was futile.

Finally, China and India, particularly the former, which were expected to serve as buffers against a slide into recession, are also experiencing a slowdown in growth. Chinas GDP grew by an otherwise credible but significantly low 7.6 per cent in the second quarter of 2012. This was the sixth consecutive quarter in which the rate had fallen. At 2011 level the GDP is estimated to have risen by 9.2 per cent. If this slowdown persists, it will only add to the woes of a slowing world economy.

But these growth numbers are relevant only as signals of a possible second crisis. The real reasons to expect such an outcome lie elsewhere. We need to begin with the nature of the pre-crisis boom to understand one of these reasons. That boom, it is now widely accepted, rode partly on a private debt-financed expenditure splurge. Households with easy access to credit bought into housing, automobiles, durables and much else to generate the demand that spurred increases in output and employment. One reason why the boom went bust was that the debt spiral proved unsustainable.

Unfortunately, built on that debt were a whole host of financial instruments derivatives that were originally seen as a means to distribute and share the risk associated with the rising volume of debt. The transfer of risk they permitted encouraged proliferation of the risk. When the debt bubble went bust so did the derivatives market, leading to insolvency or near-insolvency in the financial system, including banks. The consequence was a credit and liquidity crunch that adversely affected agents who were not overexposed to debt. This aggravated the real economy crisis that followed the collapse.

Household debt

If private debt was an essential element of the growth trajectory underlying the pre-2007 boom, returning to growth along the same trajectory requires the revival of debt. This, however, requires two developments. The first is the return to health of the financial system, so that financial intermediaries are able and willing to resume lending. The second is the repair of the damaged balance sheets of households burdened with debt, which requires besides direct action a return to assured employment and income for those hit by the recession.

The fact of the matter is that while in the original sites of the crisis, namely the United Kingdom and the U.S., the financial system in general and the banks in particular have been returned to solvency and even profit, the same cannot be said of most households and individuals. As noted above, income growth after the sharp downturn of 2008-09 has not yet returned to normal. Unemployment still remains high, varying from 4.4 and 5.6 per cent in Japan and Germany respectively, to 8.2 per cent in the U.S., 10.1 per cent in France and 21.9 and 24.6 per cent in Greece and Spain respectively.

Not surprisingly, household debt as a ratio of household disposable income is still high, with levels between 100 and 230 per cent in many. Moreover, five years after the financial crisis broke, household debt in many developed countries is above its 2000 (pre-boom) levels and close to or higher than the peak that the debt-to-disposable income ratio reached at the height of the boom (2007). This tendency for debt-financed expenditure to remain depressed even after the boom it stimulated has ended is what prolongs the recession that ensues.

By implication, in the coming months and years households are likely to focus on reducing their debt levels rather than borrowing more, and banks are unlikely to lend as easily to the household sector until they go through a phase of deleveraging or reducing their stock of past debt. Any return to a trajectory of growth in which debt-financed private expenditure plays an important part is unlikely. Rather, we can expect a reduction in debt, which would have a depressing effect on output and employment growth.

Thus, what the world economy needs today is a new stimulus that can lead the recovery and also serve as the engine for a return to growth. Trade cannot serve as that engine. The recession is generalised across countries, and not all countries can grow out of the crisis simultaneously by exploiting the markets of others. There are, inevitably, winners and losers in trade-led growth strategies, and the losers will drag the system down. Moreover, consistent losers in the middle of a recession are bound to respond with protectionist measures. Not surprisingly, not only has world trade followed world output, but the prognosis on future growth is also bleak.

Public expenditure stimulus

This leaves only one factor that can return the world system to growth, which is public expenditure in the form of both consumption and investment. Such expenditure stimulates growth directly because of the demand it generates for goods entering government consumption and for investment. And because increased public expenditure, including on public services, creates employment, such expenditure also generates demand indirectly. Both kinds of demand have, in turn, multiplier effects on output and employment.

The problem with turning to this stimulus is that it needs to be financed. Periods of recession are periods in which government revenues, both tax and non-tax, are down, because of the fall in employment, output and income. If government expenditure is tied to its revenues, such expenditure will also fall, aggravating rather than countering the recession. However, there is no reason why government expenditure should be tied to its revenues in any single period. Rather, governments can borrow by exploiting the fact that their debt is rated high and spend to pull their economies out of recession and drive growth. This would, in time, generate the increases in output and employment and, therefore, in government revenues, which would help meet the commitments associated with government debt. Autonomous government expenditure can, therefore, be countercyclical in its role and impact, unlike debt-financed private expenditure.

In fact, this is what most governments did immediately after the crisis broke: borrowed to counter the crisis. However, the expenditure that followed was of two kinds. One was bailing-out finance, especially for the banking system, through cheap loans, equity purchases and plain transfers. In most cases, large volumes of private debt accumulated by the banking system during the boom were in essence taken over by the state. The other element of expenditure that debt financed was directly aimed at reviving the real economy. Much of the governments expenditure, however, was geared to saving finance. In the event, the financial crisis was resolved partially, but the real economy languished. In fact, what the financial system did in many contexts was to borrow money from the central banks at near zero interest rates, to lend to governments that were borrowing to finance the bailout and rescue.

Debt burden

One consequence of this has been a significant increase in the debt accumulated by governments. That trend was cumulative. While borrowing increased outlays on debt service, the recession was reducing revenue generation, necessitating additional borrowing to finance the shortfall in revenue relative to expenditure. On the other hand, as government borrowing from private lenders increased, the interest charged on government debt inched upwards, increasing the burden that debt-service imposed on government budgets. The result was a significant increase in the volume of debt relative to GDP.

Between 2007 and 2012, the ratio of government debt to GDP rose by more than 200 per cent in the case of Ireland, doubled in the U.K., rose by 70 per cent in Spain and the U.S. and by 30-40 per cent in France, Portugal and Greece. In normal circumstances this increase would not have given cause for much concern. Governments, unlike the private sector, have the right to tax to raise revenues to meet debt-service commitments. However, increasing taxes during recession was not an appropriate action, and in any case it would have been opposed by the financial interests holding government debt.

As a result, the discussion soon converged on the sustainability of government debt, and governments were under pressure to cut back on expenditure to reduce borrowing and release resources to repay and reduce debt. Austerity has become the rule when expansionary spending is the need. The net result is that debt-financed public expenditure has not emerged as a substitute for debt-financed private expenditure as a stimulus for growth.

Moreover, austerity of this kind is self-defeating. By reducing demand and contracting output, there is a reduction in government revenues and an increase in the budgetary shortfall. This increases borrowing and debt dependence, as has become clear in Ireland, Greece, Spain and Portugal. The resulting threat of sovereign default makes access to additional credit dependent on more austerity, and the cycle continues. To escape from this a concerted effort is required to raise revenues through additional taxation on the rich and increasing debt-financed public expenditure. But that is exactly what has not happened and it has led to the current impasse where a second crisis is on the anvil.